Those who support the stimulus as a desperate measure to arrest the downward
plunge in the business cycle might be called cyclists. Others, including me, see
the stimulus as the first step toward addressing deep structural flaws in the
economy. We are the structuralists. These two camps are united behind the
current stimulus, but may not be for long. Cyclists blame the current crisis on
a speculative bubble that threw the economy's self-regulating mechanisms out of
whack. They say that we can avoid future downturns if the Fed pops bubbles
earlier by raising interest rates when speculation heats up.

But structuralists see it very differently. The bursting of the housing
bubble caused the current crisis, but the underlying problem began much earlier
-- in the late 1970s, when median U.S. incomes began to stall. Because wages got
hit then by the double-whammy of global competition and new technologies, the
typical American family was able to maintain its living standard only if women
went into the workforce in larger numbers, and later, only if everyone worked
longer hours.

When even these coping mechanisms were exhausted, families went into debt --
a strategy that was viable as long as home values continued to rise. But when
the housing bubble burst, families were no longer able to easily refinance and
take out home-equity loans. The result: Americans no longer have the money to
keep consuming. When you consider that consumers make up 70 percent of the
economy, the magnitude of the problem becomes apparent.

What happened to the money? According to researchers Thomas Piketty and
Emmanuel Saez, since the late 1970s, a greater and greater share of national
income has gone to people at the top of the earnings ladder. ... But the rich
don't spend as much of their income as the middle class and the poor do...
That's why the concentration of income at the top can lead to a big shortfall in
overall demand and send the economy into a tailspin. ...

Other structural problems are growing as well. One is climate change and our
dependence on oil. Another is the United States' growing reliance on foreign
capital, mostly from China, Japan and the Middle East. Neither is sustainable.

Meanwhile, our broken health-care system drains more of our dollars yet
delivers less care. ... Most cyclists acknowledge these problems, but they tend
to think of them as separate from the current crisis -- issues to be tackled
after the economy has recovered, and then only to the extent that we can afford
to do so.

But structuralists like myself don't believe that the economy can fully
recover unless these underlying problems are addressed. Without policies that
put the nation on the path to higher median incomes, higher productivity,
renewable energy and a more accessible and efficient health-care system, we'll
face deeper and more prolonged recessions...

As early as next year, the business cycle may hit bottom and begin climbing.
At that point, cyclists and structuralists will want two different things -- and
which side the president chooses will be ... the "central drama" of the Obama
administration. ...

There's also another type of structuralist found on the conservative side of
debate who focuses almost exclusively on economic growth (though some see that
as a facade for upward redistribution of income). Curiously, however, the only way to get growth is tax cuts, government investments in infrastructure - something the left sees as productive investment in public goods - are not generally favored by this group.

However, I want to make a
different point that doesn't deal directly with Reich's arguments, but it's a
point that is being overlooked too often in the debate about the recovery
package. Most observers are marking the turnaround in the economy as the point
where GDP begins to turn upward, i.e. after the trough in GDP, and expressing
worry that the stimulus package might extend beyond that point.

But looking to the last two recessions for guidance, the trough in employment
came much later than the trough in output, the traditional one quarter lag
between the upturn in GDP and the upturn in employment was extended
considerably, and once employment did turnaround, the recovery of employment was
sluggish relative to the recovery in GDP (overall job growth during the Bush
years was relatively weak).

So marking the turnaround in GDP as the turning
point in the economy rather than looking at the behavior of GDP in conjunction
with other measures such as the behavior of employment can lead policymakers to
pull back on the recovery effort too fast. If employment follows same path it
followed in the last two recessions and lags GDP considerably, the need for
stimulus in employment will extend far beyond the point where GDP begins to
recover. Thus, if some infrastructure projects cannot be completed before GDP
turns upward, and instead take a year or longer to complete - something we're
hearing a lot of worry about - that won't be a problem, just the opposite as it will provide a
helpful and needed boost to employment.

"Buy domestic" policies are individually irrational too, by Nick Rowe: Most
(all?) economists agree that in a global recession, when each country wants to
boost demand for the goods it produces, policies which steer demand to
domestically-produced goods are individually rational (provided other countries
don't retaliate), but collectively irrational when all countries do the same.

I think most economists are wrong. It's not just collectively irrational, but
individually irrational as well, at least for countries with flexible exchange
rates.

I hear that the US fiscal stimulus contains restrictions on buying imported
goods. One could perhaps argue that the Canadian fiscal stimulus also
concentrates demand on non-traded goods, and so does sort of the same thing, but
in a manner which is less provocative (or more devious, if you prefer). This is
dangerous. ... I don't have anything new to say about the collective dangers if
all countries end up restricting trade as they did in the 1930's.

But I do have something to say about the benefits to an individual country of
following this policy. Even if no other country retaliates, it is irrational for
an individual country with flexible exchange rates to follow this policy. ...

In normal times, outside of a liquidity trap, an expansionary fiscal policy
will put upward pressure on interest rates... An increase in domestic interest
rates will cause a capital account inflow, which causes the exchange rate to
appreciate. The exchange rate appreciation will cause net exports to fall. The
fall in net exports offsets the expansionary fiscal policy. Under imperfect
capital mobility the offset will be partial. Under perfect capital mobility
there will be full offset, for a small open economy. So in normal times, part or
all of the increased demand from an expansionary fiscal policy will be lost due
to a decline in net exports. Some or all of the extra demand just leaks out to
foreign countries.

But these are NOT normal times. An expansionary fiscal policy will not cause
an increase in the rate of interest. Central banks won't let it happen. The
perfectly interest-elastic demand for money won't let it happen either.

An expansionary fiscal policy ... will cause total spending to increase, and
some proportion of this increased total spending will be on imports. But an
increased demand for imports will cause an excess demand for foreign exchange on
the current account of the balance of payments. Nothing happens on the capital
account, because interest rates don't change. The excess demand for foreign
exchange causes the exchange rate to depreciate (the exact opposite of the
normal case). The exchange rate depreciation causes net exports to rise. This
will fully offset the increased imports from increased income and spending (it
has to, if the capital account stays the same). So, in the new equilibrium, all
of the increased spending goes to increased demand for domestic goods. None
leaks out to increased demand for foreign goods.

A "buy domestic" policy will not shift demand towards domestic goods. If it
did, so that imports fell and net exports increased, the current account surplus
would merely cause the exchange rate to appreciate so that net exports fell to
their original level. The current account must stay the same, because the
capital account stays the same, because the interest rate differential stays the
same, because interest rates stay the same.

My argument does not apply within the Eurozone of course. The countries share
a common currency and so there are no exchange rates to adjust. ... And it does
not apply to countries on fixed exchange rates, where the foreign country will
intervene in the foreign exchange market to prevent its currency appreciating
against our currency.

Encourage consumer spending that will continue to boost the economic
recovery and create jobs.

Promote investment by individuals and businesses that will lead to economic
growth and job creation.

Deliver critical help to unemployed citizens.

No surprise there, right? After all, President Obama has been quite clear
about his support for a stimulus plan to achieve these goals, all of which are
textbook Keynesian stuff.

Gotcha!
The White House fact sheet in question was released in the name of former
President George W. Bush, on January 7, 2003. You can
read the whole thing here (lots of plugs for tax cuts, of course).

How much does labor supply respond to changes in wealth and credit? If this research is correct, the recent declines in wealth and credit may cause increased entry into the labor market, resulting in an even higher unemployment than is currently being forecast:

Labor Supply Responses to Changes in Wealth and Credit,
by Mary Daly, Bart Hobijn, and Joyce Kwok,
FRBSF Economic Letter:
Recent declines in house prices and the stock market have led to the most
substantial contraction in household wealth since the Great Depression. From the
third quarter of 2007 through the third quarter of 2008, household wealth shrank
by $6.7 trillion (Federal Reserve Board of Governors 2008). Further declines in
financial markets and house prices in the fourth quarter undoubtedly made losses
for the full year 2008 even greater. At the same time, the severe disruptions in
financial markets have made credit unavailable or too expensive for many
households. Indeed, the third quarter of 2008 was the first time in the postwar
period that household borrowing was negative. The combination of wealth declines
and increased liquidity constraints is having a profound effect on household and
aggregate consumption. In this Economic Letter we examine how it may
also be affecting household and aggregate labor supply. Using monthly data from
the Household Survey of the Current Employment Situation Report, we find
evidence suggestive that sharply reduced wealth and liquidity are prompting
certain demographic groups to enter the labor force in greater numbers.

Which raises a question: Why has the Obama administration been silent ...
about one of President Obama’s key promises...—... guaranteed health care for
all Americans? ...

Just about all economic forecasts ... say that we’re in for a prolonged
period of very high unemployment. And high unemployment means a sharp rise in
the number of Americans without health insurance. ... Why, then, aren’t we
hearing more about ensuring health care access?

Now, it’s possible that those of us who care about this issue are reading too
much into the administration’s silence. But let me address three arguments that
I suspect Mr. Obama is hearing against moving on health care, and explain why
they’re wrong.

First, some people are arguing that a major expansion of health care access
would just be too expensive ... given the vast sums we’re about to spend trying
to rescue the economy.

But ... achieving universal coverage with a plan similar to Mr. Obama’s
campaign proposals would add “only” about $104 billion to federal spending in
2010 — not a small sum,... but not large compared with, say, the tax cuts in the
Obama stimulus plan.

It’s true that the cost of universal health care will be a continuing
expense... But ... Mr. Obama has always claimed that his health care plan was
affordable. The temporary expenses of his stimulus plan shouldn’t change that
calculation.

Second, some people in Mr. Obama’s circle may be arguing that health care
reform isn’t a priority right now, in the face of economic crisis.

But helping families purchase health insurance ... would be at least as
effective a way of boosting the economy as the tax breaks that make up roughly a
third of the stimulus plan — and it would have the added benefit of ... ending
one of the major sources of Americans’ current anxiety.

Finally — and this is, I suspect, the real reason for the administration’s
health care silence — there’s the political argument that this is a bad time to
be pushing fundamental health care reform, because the nation’s attention is
focused on the economic crisis. But if history is any guide, this argument is
precisely wrong. ...

F.D.R. was able to enact Social Security in part because the Great Depression
highlighted the need for a stronger social safety net. And the current crisis
presents a real opportunity to fix the gaping holes that remain in that safety
net, especially with regard to health care.

One more thing. There’s a populist rage building ... as Americans see bankers
getting huge bailouts while ordinary citizens suffer.

I agree ... financial bailouts are necessary (though I have problems with the
specifics). But I also agree with Barney Frank ... who argues that — as a matter
of political necessity as well as social justice — aid to bankers has to be
linked to a strengthening of the social safety net, so that Americans can see
that the government is ready to help everyone, not just the rich and powerful.

The bottom line, then, is that this is no time to let campaign promises of
guaranteed health care be quietly forgotten. It is, instead, a time to put the
push for universal care front and center. Health care now!

More Will They or Won’t They or When Will They, by Tim Duy: Thursday’s
action in the Treasury market – which saw the yield on the 10-year bond leap 18
basis points – has triggered another debate of when will the Fed begin wholesale
purchase of Treasuries to hold yields close to zero and openly expand the
monetary base. John Jansen thinks it is only a
matter of time:

One trader noted, and I concur, that traders are now engaged in a game of
financial chicken with Federal Reserve as traders attempt to force the Fed’s
hand. The Fed has no desire for higher rates and the higher rates defeats the
intent of the myriad of plans it has implemented to fight the financial crisis.
I do not know what level on 5 year or 10 year notes would invite Federal Reserve
coupon purchases. However, in this fragile environment such a level does exist
and I think that the street will now probe to discern that level.

The Federal Reserve has purchased several hundred billion mortgages and is
significantly underwater for all its efforts. They have bought big chunks of
FNMA 4s between 100 and 101. Those bonds currently trade around 99.

I mentioned in the preceding post that I thought that the street would force
the Fed’s hand regarding purchases of Treasuries. The debacle in the Treasury
market has erased the gains in the mortgage market. The Fed will not wait long
to buy Treasuries as dilatory action will only lead to higher mortgage rates.

Earlier I wrote that the Fed’s last statement, however, appears to say that
the Fed is not yet targeting the level of long rates. Instead, the Fed, using
the asset side approach to balance sheet policy, is only interested in outright
Treasury purchases if deemed supportive of maintaining normal credit market
functioning. On this point, CR
revives his series on credit crisis indicators, and concludes that we have
already seen significant improvement. Moreover, his chart of the yields on the
10-year Treasury reminds us that Treasuries remain at historically LOW levels,
and could rise quite a bit and still be “low.” Another sign of
normality:

The difference between 10-year Treasury Inflation Protected Securities and
nominal Treasuries rose to one percent for the first time in more than three
months as traders brace for government-induced inflation.

As markets heal, we would expect investors to move out of low-yield risk-free
assets and into other, higher yielding assets, thereby improving yield spreads.
A rise in the 10-year Treasury back to 4%, in such an environment, should be
seen as a welcome indication of improving financial health. But that might
entail rate increases in some consumer loans as well, including all important
mortgages. Therein lays the conundrum – if markets conditions normalize, will
the Fed breath sigh of relief, pat themselves on the back, and walk away? Or
will Fed Chairman Ben Bernanke climb aboard his helicopter?

Moreover, we have been working on the assumption that governments around the
world can turn the fiscal faucets on full blast because there are endless
amounts of excess saving that can be sucked up and put to productive use. I
would not throw away that story just yet; I think in a normalizing financial
environment rates could back up to 4% without cause for alarm. But the US
government alone is asking markets to absorb an ever rising amount of debt. And
the US still runs a current account deficit, meaning we still need external
financing resources. So I would not be surprised to see rates start to rise; I
have said before that the key to getting fiscal stimulus right is listening to
the market signals; if rates start moving steadily upward beyond 4%, authorities
should carefully consider the possibility that they have gone overboard.

If rates are rising simply due to financial healing or obvious strains on the
capacity of the debt markets to absorb endless trillions of US debt (which, by
the way, would be something of a surprise given the steady willingness to absorb
seemingly endless debt since the Reagan Administration), the room for policy
error is great. If the Federal Reserve chooses to lean against the market and
start effectively monetizing fiscal spending, I think we could all agree that we
would be moving into an inflationary environment. Sell the Dollar, buy
commodities. On the upside, some serious inflation would reduce the debt
overhang in real terms.

Note that I am not saying we are at this point; it is just one risk in a
range of possibilities. A fresh bout of financial fever could send rates back
toward the 2% mark, and that would end this story entirely.

In short, the Fed opened something of a can of worms by offering up Treasury
purchases as an option in the monetary policy arsenal – they left open the
question of what would trigger them to use that weapon. Only if necessary for
the smooth functioning of financial markets? Or to hold rates artificially low?
By my read, the most recent statement suggests the former. But I will also be
the first to admit that Bernanke has tended to error on the side of more policy
is better.

Jeff Sachs seems to be pleased with the new administrations commitment to "a
new age of sustainable development":

Rewriting the rulebook for 21st-century capitalism, by Jeffrey Sachs, CIF, The
Guardian: One of President Barack Obama's historic contributions will be a
grand act of policy jujitsu - turning the crushing economic crisis into the
launch of a new age of sustainable development. ... Obama is already setting a
new historic course by reorienting the economy from private consumption to
public investments directed at the great challenges of energy, climate, food
production, water and biodiversity.

The new president has taken every opportunity to underscore that the economic
crisis will not slow, but rather will accelerate, the much-needed economic
transformation to sustainability. ... The fiscal stimulus ... will lay down the
first steps of a massive generation-long technological overhaul...

Obama has started with the most important first step: a team of scientific
and technological advisers of stunning quality... He has also focused on two
core truths of sustainable development: that technological overhaul lies at the
core of the challenge, and that such an overhaul requires a public-private
partnership for success. Taking shape, therefore, is nothing less than a new
21st-century model of capitalism ... committed to the dual objectives of
economic development and sustainability...

Consider the challenge of a bankrupt automobile sector... In the Obama
strategy, GM will not be closed to punish it... It's worth far too much as a
world leader in the electric vehicles of the 21st century. ...

Conservatives are aghast. The bail-out of the auto industry was hard enough
to swallow. Government investments in infrastructure and research and
development are viewed with scorn, compared with the tried and true (if
disastrously failed) tax cuts of the Bush era. Rightwing pundits bemoan the
evident intention of Obama and team to "tell us what kind of car to drive". Yet
that is exactly what they intend to do (at least with regard to the power source
under the hood), and rightly so. Free-market ideology is an anachronism in an
era of climate change, water stress, food scarcity and energy insecurity.
Public-private efforts to steer the economy to a safe technological harbour will
be the order of the new era.

There is plenty of room for blunders... Government activism can founder on
the shoals of massive budget deficits, tax-cutting populism pushed by the right,
politically motivated investments such as corn-based ethanol..., and more. Yet
Obama is absolutely correct that we have no choice but to try. ...

The Global Crisis Debate: VoxEU.org is partnering with the UK government to collect the views of
economists from around the world on what we should do to fix the global economy.
The analysis and proposals that appear on Vox's "Global Crisis Debate" page will
feed directly into the UK's preparation for the summit of world leaders in
London in April. This debate will be featured on the UK government's own web
site, http://www.LondonSummit.gov.uk.

Development and the
crisis Moderator: Dani Rodrik - How is the crisis different for
developing and emerging nations, how should they and the G20 react?

Open markets
Moderator: VoxEditor - What should be done to maintain open markets and
promote an environmentally sound recovery?

Help us make this the global debate on the global crisis
The Editors invite all professional economists to write 200-1000 word
Commentaries on the crisis. These need not be original (for example you might
cut-and-paste-and-update a recent column posted or published elsewhere); our aim
is to agglomerate all the best thinking in one place to better foster dialog and
exchange. [Rules for
contributing.]

Here's a sample contribution, one of the lead essays for the Macroeconomics
section:

Getting past the blame
game, by Eswar Prasad: Who’s to blame for the worldwide financial crisis?
The list of potential culprits for the meltdown of the US financial system is
long and the rogues’ gallery will no doubt expand a great deal before the
economy is out of the woods. But a worldwide crisis calls for a global villain.
And there is indeed one at hand – global macroeconomic imbalances, characterised
by large current account deficits in the US and a few other advanced industrial
countries, with these deficits financed by excess savings in China and many
other emerging market economies.

When somebody sent me this
invitation from Antonio Guterres, the UN High Commissioner for Refugees, I
thought at first it was a joke from the Onion. What do you think of the Davos
rich and powerful going through the “Refugee Run” theme park re-enactment of
life in a refugee camp?

Can Davos man empathize with refugees when he or she is not in danger and is
going back to a luxury banquet and hotel room afterwards? Isn’t this just a tad
different from the life of an actual refugee, at risk of all too real rape,
murder, hunger, and disease?

Did the words “insensitive,” “dehumanizing,” or “disrespectful” (not to
mention “ludicrous”) ever come up in discussing the plans for “Refugee Run”?

I hope such bad taste does not reflect some inability in UNHCR to see
refugees as real people with their own dignity and rights.

Of course, I understand that there were good intentions here, that you really
want rich people to have a consciousness of tragedies elsewhere in the world,
and mobilize help for the victims. However, I think a Refugee Theme Park crosses
a line that should not be crossed. Sensationalizing and dehumanizing and
patronizing results in bad aid policy – if you have little respect for the
dignity of individuals you are trying to help, you are not going to give THEM
much say in what THEY want and need, and how you can help THEM help themselves? ...

Here’s a resolution to be proposed at Davos: we rich people hereby recognize
each and every citizen of the globe as an individual with their own human
dignity equal to our own, regardless of their poverty or refugee status. And
Davos man: please give Refugee Run a pass.

Wednesday, January 28, 2009

Quick Note on the FOMC Statement, by Tim Duy: Many will parse today’s
FOMC statement; I will keep my comments focused on the sentence:

The Committee also is prepared to purchase longer-term Treasury securities if
evolving circumstances indicate that such transactions would be particularly
effective in improving conditions in private credit markets.

Conventional wisdom has that any Fed action to purchase longer-term
Treasuries would be done with the intent of holding interest rates low, thereby
stimulating economic activity. That, however, is not the implication of this
sentence. Instead, the Fed views Treasury purchases only as a mechanism to
support effective functioning of credit markets, which suggest that the Fed is
not worried about controlling the level of longer term interest rates, but the
spread between Treasuries and other assets.

This also suggests that the Fed is not particularly interested in expanding
the balance sheet further via Treasury purchases. They may be willing to, but I
am not sure how Treasury purchases will improve market functioning. To date,
improving credit market efficiency has meant purchasing or holding as collateral
risky assets, or even safe assets that the market currently shuns, not riskless
Treasuries. What factors would cause a reversal of that position?

Moreover, one should also question the willingness of the Fed to fight
against rising interest rates if those rising rates were the result of a shift
to riskier assets and credit spreads fell to more normal levels. Presumably,
this would correspond to a loosening of credit conditions, which in and of
itself would be stimulative even if rates edged upward.

In short, as long as the Fed is focused on the issue of improving credit
markets – what they view as the asset side of the balance sheet – they are not
likely to engage in Treasury purchases that effectively shift policy to the
liabilities side of the balance sheet. This shift, however, is what Richmond Fed
President Jeffery Lacker wants to see:

Voting against was Jeffrey M. Lacker, who preferred to expand the monetary
base at this time by purchasing U.S. Treasury securities rather than through
targeted credit programs.

Lacker views the Fed’s
adherence to its asset side approach as an encroachment on the role of the
fiscal authorities (not to mention a power grab by the Board). He would prefer
the Fed conduct straightforward monetary policy – drive up the monetary base,
effectively monetizing deficit spending. His colleagues are not there yet.

Fiscal policy formalities (wonkish), by Paul Krugman: There seems to be an
amazing amount of misunderstanding of the basics of fiscal policy, even among
people who should know better. Leave on one side the remarkable parade of
economists who think that the savings-investment identity proves that government
action can’t increase spending;
PGL points us to a higher-level fallacy: the widespread belief that
Ricardian equivalence doesn’t just say that tax cuts have no effect — which it
does — it also says that private consumption automatically offsets any rise in
government spending, which is just wrong.

Justin Wolfers suggests that this is because economists just haven’t been
thinking and writing about fiscal policy. Maybe. But in my own neck of the
woods, that isn’t true. In the
New
Open Economy Macroeconomics, which dates back to classic work by Obstfeld
and Rogoff in the early 90s, both fiscal and monetary policy are usually
analyzed.

And by the way: these are extremely buttoned-down models, with lots of
intertemporal maximization, careful attention to budget constraints, and at most
some assumption of temporary price rigidity. Nobody who was at all familiar with
this literature could make the logic mistakes that are coming fast and furious
from the
fresh-water economists.

What this reveals, I think, is just how insular part of the macroeconomics
profession has become. They just don’t read anything that doesn’t come from
their cult circle; they just
weren’t aware of major bodies of work that didn’t happen to be in their
preferred style.

This insularity is asymmetric. Ask a PhD student at Princeton what a real
business cycle theorist would say about something, and he or she can do that;
ask a student at one of the freshwater schools what a new Keynesian would say,
and I doubt that he or she could answer. They’ve been taught that there is one
true faith, and have been carefully protected from heresy.

It’s a sad story.

It's even sadder. The two groups have lots to offer, New Keynesians can learn
from RBC theorists, and the reverse is true as well, but ideological
hard-headedness driven by a turf war among the leaders in each group, a war that
is really about a quest for for professional fame has, I think, kept these two
groups in opposition to the detriment of the profession.

There is currently a movement within the economics profession to [synthesize real business cycle and new Keynesian models]. Real
business cycle models, i.e. supply-side models, are adequate models of the
long-run but do not explain demand side short-run economic fluctuations very
well. Because of this, they are limited in their applicability. Models with wage
and price rigidities, New Keynesian models, do have the ability to explain such
short-run fluctuations but pay scant attention to long-run issues. Combining
these two models, a real business cycle model for the long-run and a New
Keynesian model of wage and price rigidity for the short-run, is a promising
avenue for explaining macroeconomic fluctuations.

Olivier Blanchard explores this idea in more detail in "The State of Macro."
Here's a bit of the paper (I can't find an open link - Update:
open link
- click on "choose download location" at top of page):

The theme is that, after the explosion (in both the positive and negative
meaning of the word) of the field in the 1970s, there has been enormous progress
and substantial convergence. For a while - too long a while - the field looked
like a battlefield. Researchers split in different directions, mostly ignoring
each other, or else engaging in bitter fights and controversies. Over time
however, largely because facts have a way of not going away, a largely shared
vision both of fluctuations and of methodology has emerged. Not everything is
fine. Like all revolutions, this one has come with the destruction of some
knowledge, and suffers from extremism, herding, and fashion. But none of this is
deadly. The state of macro is good.[2] ...

1 A Brief Review of the Past

When they launched the "rational expectations revolution", Lucas and Sargent
(1978) did not mince words:

That the predictions [of Keynesian economics] were wildly incorrect, and that
the doctrine on which they were based was fundamentally flawed, are now simple
matters of fact, involving no subtleties in economic theory. The task which
faces contemporary students of the business cycle is that of sorting through the
wreckage, determining what features of that remarkable intellectual event called
the Keynesian Revolution can be salvaged and put to good use, and which others
must be discarded.

They predicted a long process of reconstruction:

Though it is far from clear what the outcome of this process will be, it is
already evident that it will necessarily involve the reopening of basic issues
in monetary economics which have been viewed since the thirties as "closed" and
the reevaluation of every aspect of the institutional framework within which
monetary and fiscal policy is formulated in the advanced countries. This paper
is an early progress report on this process of reevaluation and reconstruction.

They were right. For the next fifteen years or so, the field exploded. Three
groups dominated the news, the new-classicals, the new-Keynesians, and the
new-growth theorists (no need to point out the PR role of "new" here), each
pursuing a very different agenda:

The new-classicals embraced the Lucas-Sargent call for reconstruction. Soon,
however, the Mencheviks gave way to the Bolcheviks, and the research agenda
became even more extreme. Under Prescott's leadership, nominal rigidities,
imperfect information, money, and the Phillips curve, all disappeared from the
basic model, and researchers focused on the stochastic properties of the Ramsey
model (equivalently, a representative agent Arrow-Debreu economy), rebaptized as
the Real Business Cycle model, or RBC. Three principles guided the research:

Explicit micro foundations, defined as utility and profit maximization;
general equilibrium; and the exploration of how far one could go with no or few
imperfections.

The new-Keynesians embraced reform, not revolution. United in the belief that
the previous vision of macroeconomics was basically right, they accepted the
need for better foundations for the various imperfections underlying that
approach.

The research program became one of examining, theoretically and empirically,
the nature and the reality of various imperfections, from nominal rigidities, to
efficiency wages, to credit market constraints. Models were partial equilibrium,
or included a trivial general equilibrium closure: It seemed too soon to embody
each one in a common general equilibrium structure.

The new-growth theorists simply abandoned the field (i.e. fluctuations).
Lucas' remark that, once one thinks about growth, one can hardly think about
something else, convinced many to focus on determinants of growth, rather than
on fluctuations and their apparently small welfare implications. ...

Relations between the three groups - or, more specifically, the first two,
called by Hall "fresh water" and "salt water" respectively (for the geographic
location of most of the new-classicals and most of the new-Keynesians) - were
tense, and often unpleasant. The first accused the second of being bad
economists, clinging to obsolete beliefs and discredited theories. The second
accused the first of ignoring basic facts, and, in their pursuit of a beautiful
but irrelevant model, of falling prey to a "scientific illusion." (See the
debate between Prescott and Summers (1986)). One could reasonably despair of the
future of macro (and, indeed, some of us came close (Blanchard 1992)).

This is still the view many outsiders have of the field. But it no longer
corresponds to reality. Facts have a way of eventually forcing irrelevant theory
out (one wishes it happened faster). And good theory also has a way of
eventually forcing bad theory out. The new tools developed by the new-classicals
came to dominate.

The facts emphasized by the new-Keynesians forced imperfections back in the
benchmark model. A largely common vision has emerged, which is the topic of the
next section.

2 Convergence in Vision

2.1 The role of aggregate demand, and nominal rigidities

It is hard to ignore facts. One major macro fact is that shifts in the
aggregate demand for goods affect output substantially more than we would expect
in a perfectly competitive economy. More optimistic consumers buy more goods,
and the increase in demand leads to more output and more employment. Changes in
the federal funds rate have major effects on real asset prices, from bond to
stock prices, and, in turn, on activity.

These facts are not easy to explain within a perfectly competitive
flexible-price macro model. ...

Attempts to explain these effects through exotic preferences or exotic
segmented-market effects of open market operations, while maintaining the
assumption of perfectly competitive markets and flexible prices, have proven
unconvincing at best. This has led even the most obstinate new-classicals to
explore the possibility that nominal rigidities matter. ...

The study of nominal price and wage setting is one of the hot topics of
research in macro today. ... The cast of characters involved ... nicely makes
the point that the old fresh water/salt water distinction has become largely
irrelevant: While research on the topic started with new-Keynesians, recent
research has been largely triggered by an article by Golosov and Lucas (2007),
itself building on earlier work on aggregation of state-dependent rules by
Caplin and by Caballero, among others.

2.2 Technological shocks versus technological waves

One central tenet of the new-classical approach was that the main source of
fluctuations is technological shocks. The notion that there are large
quarter-to-quarter aggregate technological shocks flies however in the face of
reason. Except in times of dramatic economic transition,... technological
progress is about the diffusion and implementation of new ideas, and about
institutional change, both of which are likely to be low-frequency movements. No
amount of quarterly movement in the Solow residual will convince the skeptics:
High frequency movements in measured aggregate TFP must be due to measurement
error.[3]

This does not imply, however, that technological progress does not play an
important role in fluctuations. Though technological progress is smooth, it is
certainly not constant. There are clear technological waves. ...

2.3 Towards a general picture, and three broad relations

The joint beliefs that technological progress goes through waves, that
perceptions of the future affect the demand for goods today, and that, because
of nominal rigidities, this demand for goods can affect output in the short run,
nicely combine to give a picture of fluctuations which, I believe, many
macroeconomists would endorse today.

Fifty years ago, Samuelson (1955) wrote:

In recent years, 90 per cent of American economists have stopped being
"Keynesian economists" or "Anti-Keynesian economists." Instead, they have worked
toward a synthesis of whatever is valuable in older economics and in modern
theories of income determination. The result might be called neo-classical
economics and is accepted, in its broad outlines, by all but about five per cent
of extreme left-wing and right-wing writers.

I would guess we are not yet at such a corresponding stage today. But we may
be getting there. ...

When I first posted this, I agreed. The two sides seemed to be converging and
I thought that was a good development. But the current crisis has reopened old
debates, exposed divisions that have never been fully healed, and we seem as far
apart as ever.

I want to end with this quote from Lucas:

The task which
faces contemporary students of the business cycle is that of sorting through the
wreckage, determining what features of that remarkable intellectual event called
the Keynesian Revolution can be salvaged and put to good use, and which others
must be discarded.

What's different this time, and it's a difference I hope will bring about some humility, is that the wreckage is not from the Keynesian model crashing, this time it is the Classical formulation of the world that is being called into question. Once the proponents of these models are willing to concede that point, something they are currently resisting, maybe we can come together and get somewhere useful.

The Federal Open Market Committee decided today to keep its target range for
the federal funds rate at 0 to 1/4 percent. The Committee continues to
anticipate that economic conditions are likely to warrant exceptionally low
levels of the federal funds rate for some time.

The most obvious problem with the stimulus package is that it has been turned
into a fiscal piñata – with a mad scramble for candy on the floor. We seem all
too eager to rectify a generation of a nation saving too little by saving even
less – this time through expanding government borrowing. ..

The White House and Congress have stated an amount – $825bn to be spent
mostly over two years... Many of the details of allocating the $825bn are being
left to Congress with the aim of reaching a bipartisan consensus. The result is
shaping up to be an astounding mish-mash of tax cuts, public investments,
transfer payments and special treats for insiders.

What we need is a medium-term fiscal framework, one that lays out an
anticipated schedule of taxes and spending consistent with the needs of the
economy and government functions. Rather than soundbites about ending
pork-barrel projects or scouring the budget for waste, or about the relative
multipliers of tax cuts versus spending increases..., we should be reflecting on
certain basic fiscal facts, the most important of which is that the US
government faces huge and potentially debilitating structural deficits as far as
the eye can see. ...

If the present stimulus package is adopted without a medium-term plan, it
will ... put the US into a fiscal straitjacket that could paralyze public sector
action in critical areas for a decade or more to come. This is especially true
if we allow further tax cuts during a time of fiscal hemorrhage, or give into
“bipartisan” demands to make the Bush tax cuts permanent, even for the rich, as
seems increasingly likely.

There are many valuable things proposed in President Barack Obama’s spending
plans – such as the sums to be spent on energy, healthcare and education – but
these should be incorporated into medium-term strategies rather than a grab bag
of hasty short-run spending. The tax cuts that he is likely to approve..., and
the extension of Bush-era tax cuts if that comes to pass, could close the door
to these longer-term programs; haphazard spending on these vital programs
could do the same. ...

[T]here is certainly a cyclical case for deficit- financed public spending,
but accompanied by phased-in tax increases to provide proper financing of
crucial government functions in the medium term.

Passing the Baton, by Tim Duy: The Federal Reserve will offer up the
results of its two day meeting this afternoon. It is hard to find much to argue
with Rebecca Wilder’s conclusion
that not much has changed in the past six weeks, and hence we should expect
little from today’s statement. CR
opines on the possibility that Bernanke & Co. might update us on their
evaluation of the potential benefit of purchasing longer dated Treasuries.
Economists at Merrill Lynch
suggested earlier this week the Fed may be forced to pursue that option
sooner rather than later if yields keep rising (although some think that bonds
are about to make a technical turn in direction anyway).

It seems, however, that outright purchases of Treasuries to hold rates lower
would shift the Fed’s attention from the asset side of the balance sheet to the
liabilities side, which would put them in the realm of their definition of
quantitative easing. It doesn’t seem like they are quite ready to go there; just
six weeks ago they made an effort to differentiate between their policy and
Japanese style quantitative easing. Seems too quick for a reversal given the
relative calm of credit markets since the December meeting. Given the lack of
Fed preconditioning to expect a significant policy shift, today’s statement is
not expected to move markets, and will be carefully dissected to see how, if
any, the Fed’s view of the economy or credit markets have changed.

So what now is the ultimate intention of policymakers? What do they hope to
accomplish?

Arnold Kling has already attempted
to explain things to Wilkinson. ... Kling discusses the policy advice of
macroeconomists (and Fama). Not all economists are macroeconomists who think
that it is there job to offer policy advice. He notes two divisions left and
right and fresh water and salt water.

Left and right correspond fairly closely to libertarian vs egalitarian in the US
political spectrum, that is, closely to Democratic vs Republican positions on
economics (except that there are leading economists well to the left of the
Democratic party and well to right of all but the left fringe of the Republican
party). ... This is a wide enough ideological range that the methods of
verification used by economists are absolutely unable to force economists on
left and right to admit that economists on right and left have a point.

In the field of macroeconomics there is a much deeper division between
macroeconomics as practiced at universities closer to the great lakes than to an
Ocean (Fresh water economics) and that practiced at universities closer to
Oceans (Salt water economics). The geography has shifted some as Fresh water
economics has been exported. ... It is a little difficult to explain the
disagreement to non economists. Frankly, I think this is because non-economists
have difficulty believing that any sane person would take fresh water economics
seriously.

Under normal circumstances, I would oppose this rise in the budget deficit
and the higher level of government spending. When an economy is closer to full
employment, government borrowing to finance budget deficits can crowd out
private investment... Budget deficits automatically increase government debt,
requiring higher future taxes... The resulting higher tax rates distort economic
incentives and thus weaken future economic performance. ...

Now, however, increased government spending and the resulting rise in the
fiscal deficit are being justified as necessary to deal with the economic
downturn... I support the use of fiscal stimulus in the US, because the
current recession is much deeper than and different from previous downturns.
Even with successful countercyclical policy, this recession is likely to last
longer and be more damaging than any since the depression of the 1930’s. ...

The usual monetary-policy response of lowering interest rates is unable to
reverse this sharp drop in demand. ... So there is no alternative to fiscal
policy if we want to reverse the current downturn. The resulting increase in the
national debt is the price that we and future generations will pay for the
mistakes that created the current economic situation. ...

The GSEs should be preserved, mainly because they
are the most effective institutions for providing liquidity to the
mortgage market. Most mortgage investors, including
depositories, prefer to hold liquid securities rather than illiquid
whole loans. Wall Street securitization is not a substitute.

Fannie and Freddie should be chartered as
special-purpose banks, playing their historical roles of securitizing
mortgages and holding some portfolio of loans. Their debt
should be federally insured or guaranteed, as are the deposits of
banks, and as with banks, the equity of the institutions should be the
first backup to bondholders as the capital (or equity) of banks is the
first backup to deposits. Their insured or guaranteed debt should not
be counted as part of federal debt, as the insured deposits of banks
are not. They should be subject to capital standards and supervision of
their activities, and subject to restrictions on their activities, like
banks. The capital standards, activity restrictions, and supervision need not be identical to those of banks.

It is important to have two GSEs to assure competitive pricing of the guarantees on mortgages which go into MBS pools. Guarantee fees are not posted prices, but negotiated in secret. As a result, the pricing of guarantee fees is not collusive but close
to perfect (Bertrand) competition with two GSEs. In the trade-off of
standardization and homogeneity to promote liquidity (which calls for
fewer GSEs) vs. competition to assure competitive pricing (which calls
for more), two gets an excellent result, likely the best result.

There are three choices for F&F ownership: 1)
owned by the government, like FHA and Ginnie Mae; 2) owned as a
cooperative, by member institutions, as both once were, and 3) owned by
the general public. Fannie and Freddie should be owned by public
shareholders, as banks are. We advocate ownership as public companies, but with explicit and priced federal backing, like banks.

Quoting an email [from Paul Krugman], economists who "have spent their entire careers on
equilibrium business cycle theory are now discovering that, in effect, they
invested their savings with Bernie Madoff." I think that's right, and as they
come to this realization, we can expect these economists to flail about defending the
indefensible, they will be quite vicious at times, and in their panic to defend
the work they have spent their lives on, they may not be very careful about the arguments they make. I
don't know if the defenders of the classical faith have come to this realization
yet, at least beyond the subconscious level, and the profession will most likely
move in the same old direction for awhile due to research inertia if nothing else. But I
think what has happened will have a much bigger impact on the profession and the
models it uses to describe the world than most economists currently realize:

A Dark Age of macroeconomics (wonkish), by Paul Krugman:
Brad DeLong is upset about the stuff coming out of Chicago these days — and
understandably so. First
Eugene Fama, now
John Cochrane, have made the claim that debt-financed government spending
necessarily crowds out an equal amount of private spending, even if the economy
is depressed — and they claim this not as an empirical result, not as the
prediction of some model, but as the ineluctable implication of an accounting
identity.

There has been a tendency, on the part of other economists, to try to provide
cover — to claim that Fama and Cochrane said something more sophisticated than
they did. But if you read the original essays, there’s no ambiguity — it’s pure
Say’s Law, pure “Treasury view”, in each case. Here’s Fama... And here’s
Cochrane...

There’s no ambiguity in either case: both Fama and Cochrane are asserting
that desired savings are automatically converted into investment spending, and
that any government borrowing must come at the expense of investment — period.

What’s so mind-boggling about this is that it commits one of the most basic
fallacies in economics — interpreting an accounting identity as a behavioral
relationship. Yes, savings have to equal investment, but that’s not something
that mystically takes place, it’s because any discrepancy between desired
savings and desired investment causes something to happen that brings the two in
line. ... [A]fter a change in desired savings or investment..., if interest
rates are fixed, what happens is that GDP changes to make S and I equal.

That’s actually the point of one of the ways multiplier analysis is often
presented to freshmen. Here’s the
diagram...

In this picture savings plus taxes equal investment plus government spending,
the accounting identity that both Fama and Cochrane think vitiates fiscal policy
— but it doesn’t. An increase in G doesn’t reduce I one for one, it increases
GDP, which leads to higher S and T.

Now, you don’t have to accept this model as a picture of how the world works.
But you do have to accept that it shows the fallacy of arguing that the
savings-investment identity proves anything about the effectiveness of fiscal
policy.

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics.
Remember, what defined the Dark Ages wasn’t the fact that they were primitive —
the Bronze Age was primitive, too. What made the Dark Ages dark was the fact
that so much knowledge had been lost, that so much known to the Greeks and
Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the
economics profession. The knowledge that S=I doesn’t imply the Treasury view —
the general understanding that macroeconomics is more than supply and demand
plus the quantity equation — somehow got lost in much of the profession. I’m
tempted to go on and say something about being overrun by barbarians in the grip
of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.

Given their understanding of macroeconomics, and I mean the basics not the
hard stuff, it's becoming a lot easier to understand how financial economists
missed the developing bubble and the effect it would have on the macroeconomy.
We specialize mightily in academic economics, people will work on very narrow
questions for their entire careers and become world class experts on that
question, but they tend to forget what they learned in other areas over time,
and they can't possibly keep up with developments outside their areas of
specialization. So we rely and depend upon the expertise of others to inform us
about areas in which we don't normally work. One thing I've learned from the current episode is
not to automatically trust that the most well-known economists in the field have
done due diligence before speaking out on an issue, even when that issue is of great public importance, or even to trust that they've thought very hard about the
problems they are speaking to. I used to think that, for the most part, the
name brands in the field would live up to their reputations, that they would
think hard about problems before speaking out in public, that they would provide
clarity and insight, but they haven't. In fact, in many cases they have
undermined their reputations and confused the issues. People have been
deferential in the past, myself included, and these people have been given
authority in the public discourse - even when they are demonstrably wrong their arguments
show up in the press as a "he said, she said" presentation. But, unfortunately
for the economics profession and for the public generally, the so called best
and brightest among us have not lived up to the responsibilities that come with the prominent positions that they hold.

The term "animal spirits," popularized by ... Keynes..., is related to
consumer or business confidence, but it means more than that. It refers also to
the sense of trust we have in each other, our sense of fairness in economic
dealings, and our sense of the extent of corruption and bad faith. When animal
spirits are on ebb, consumers do not want to spend and businesses do not want to
make capital expenditures or hire people. ...

Animal spirits offer an explanation for why we get into recessions in the
first place -- for why the economy fluctuates as it does. ... A critical aspect
of animal spirits is trust, an emotional state that dismisses doubts about
others. In talking about animal spirits, Keynes sought to convey ... that swings
in confidence are not always logical. The business cycle is in good part driven
by animal spirits. There are good times when people have substantial trust...
They make decisions spontaneously. They believe instinctively that they will be
successful... As long as large groups of people remain trusting, people's
somewhat rash, impulsive decision-making is not discovered.

Unfortunately, we have just passed through a period in which confidence was
blind. It was not based on rational evidence. The trust in our mortgage and
housing markets that drove real-estate prices to unsustainable heights is one of
the most dramatic examples of unbridled animal spirits we have ever seen. ...

The danger at this point is that ... confidence will continue to plummet. ...
So what must we do to revive our animal spirits...? We must be certain that
programs to solve the current ... crisis are large enough, and targeted broadly
enough, to impact public confidence. Not only do we need a fiscal stimulus
significantly greater than the proposal ... currently on the table, government
action is also needed to take the place of the credit markets... The Treasury
and the Federal Reserve not only need a fiscal target, they also need a credit
target. This should not be a dollar number, but rather a target for how the
credit markets should behave. The goal should be that those who would normally
receive credit in times of full employment can once again find it easy to do
so...

The interventions so far have been in the right direction. Federal Reserve
Chairman Ben Bernanke has been especially inventive and aggressive. But ... a
great deal more still needs to be done. Now is not a time for the timid. ...

In due course our animal spirits will once again turn positive, but we would
rather that happen this year or the next rather than five or 10 years from now.
There is only one way to speed this process: greatly expand governmental support
of credit markets and pass a much larger fiscal stimulus plan than is now
proposed.

Monday, January 26, 2009

Brad DeLong is frustrated. People arguing that government spending displaces private consumption and investment on a one-to-one basis don't seem to realize that their argument rests on the (indefensible) presumption of a constant money multiplier and a constant velocity of money:

Fiscal Fallacies: First, if money is not going to be printed, it has to come
from somewhere. If the government borrows a dollar from you, that is a dollar
that you do not spend, or that you do not lend to a company to spend on new
investment. Every dollar of increased government spending must correspond to one
less dollar of private spending. Jobs created by stimulus spending are offset
by jobs lost from the decline in private spending. We can build roads instead of
factories, but fiscal stimulus can’t help us to build more of both. This is just
accounting, and does not need a complex argument about “crowding out”...

Let us take this slowly.

Suppose that we have four agents: Alice, Beverly, Carol, and Deborah.

Suppose that Beverly has $500 in cash that she owes Carol, due in two months.
Suppose that Alice and Carol are both unemployed and idle.

In one scenario in two months Beverly goes to Carol and pays her the $500.
End of story.

In a second scenario Beverly says to Alice: "I have a house. Why don't you
build a deck--I will pay you $500 after the work is done. Here is the contract."
Alice takes the contract and goes to Carol. She shows the contract to Carol and
says: "See. I will be good for the debt. Cook me meals so I will have the
strength to build the deck--here's another contract in which I promise to pay
you $500 within 90 days if you cook for me." Carol agrees.

Alice then asks Beverly for payment. Beverly says: "Wait a minute." She goes
to Carol and says: "Here is the the $500 cash I owe you." Beverly pays the money
to Carol. Beverly then says: "But now could I borrow the cash back by offering
you a long-term mortgage at an attractive interest rate secured with an interest
in my newly more-valuable house?" Carol says: "Sure." Beverly files an amended
deed showing Carol's mortgage lien with the town office. Carol gives Beverly
back the $500. Beverly then goes to Alice and pays her the $500. Alice then goes
to Carol and pays her the $500.

The net result? (a) Alice who would otherwise have been idle has been
employed--has traded her labor for meals. (b) Carol who would otherwise have
been idle has been employed--has traded her labor for a secured lien on
Beverly's house. (c) Beverly has taken out a mortgage on her house and in
exchange has gotten a deck built. (d) Carol has the $500 cash that Beverly owed
her in the first place.

Alice has more income and consumption expenditure than if she hadn't taken
Beverly's job offer. Carol has more income and saving than if she hadn't cooked
for Alice and then invested her earnings with Beverly. Beverly has an extra
capital asset (the deck) and an extra financial liability (the mortgage) than if
she had never offered to hire Alice.

A deck has gotten built. Meals have been cooked and eaten. Two women have
been employed. And all this has happened without printing any extra money.

John Cochrane would say that this is impossible. John Cochrane would say:

[I]f money is not going to be printed, it has to come from somewhere. If
Beverly borrows a dollar from Carol, that is a dollar that Carol does not spend,
or does not lend to Deborah to spend on new investment. Every dollar of
increased Beverly spending must correspond to one less dollar of Carol or
Deborah spending. Alice's job created by Beverly spending is offset by a job
lost from the decline in Carol or Deborah spending. We can build decks instead
of fountains, but Beverly stimulus can’t help us to build more of both. This is
just accounting, and does not need a complex argument about “crowding out”...

John Cochrane is wrong.

You sometimes see this mistake in freshmen students in Economics 1, students
who do not fully understand either the circular flow of economic activity or
what a credit economy is. They think--like Cochrane--that the flow of spending
must be constant unless somebody "prints money" because, you see, you
need "money" in order to buy things.

The premise is true--you do need "money" to buy things--but the conclusion is
false: the flow of spending is not necessarily constant. In the world in which
Beverly does not hire Alice but instead pays the $500 directly to Carol, that
$500 turns over only once--its velocity of circulation is equal to one. In the
world in which Beverly does hire Alice, the velocity of circulation of the $500
is four--it goes from Beverly to Carol, from Carol to Beverly, from Beverly to
Alice, and from Alice to Carol.

Cochrane's mistake--an elementary, freshman mistake--is because he has not
thought enough about how a credit economy works to recognize that the velocity
of circulation can be an economic variable and is not necessarily a
technological constant. And as the velocity of circulation varies, the amount of
the flow of spending varies as well: it is now longer the case that if Beverly
borrows a dollar from Carol that is a dollar that Carol does not spend.

Milton Friedman knew this. Irving Fisher knew this. Simon Newcomb knew this.
David Hume knew this. John Cochrane does not know this: does not know that the
velocity of circulation is an economic variable rather than a technological
constant.

Has it occurred to either of you that we have Greg Mankiw approvingly posting
links to Barro, and also to John Taylor arguing that a perm tax
cut counts as a stimulus?

While we're at it, in quoting an abstract from Mountford
& Uhlig's paper, he bolds the last sentence:

We find that deficit-financed tax cuts work best among these three scenarios
to improve GDP, with a maximal present value multiplier of five dollars of total
additional GDP per each dollar of the total cut in government revenue five years
after the shock.

Multiplier of 5, 5 years later. Boy, you can't reject Ricardian equivalence
much more emphatically than that. Yet Kevin Murphy, in the slides Brad posted
yesterday, touts the idea.

I'm willing to give up on getting righty economists to provide a serious
defense of their positions. At this point, I would settle for their

1. dividing into the camps that do and don't believe in Ricardian equivalence
so the rest of us know, and

2. fighting it out among each other before they try and convince anyone else
that it's simultaneously true that

(a) stimulus is unnecessary,
(b) it's impossible for a stimulus to do anything due to identities and R
equivalence, and
(c) tax cuts--permanent ones!--are the best way to stimulate AD.

Bad Faith Economics, by Paul Krugman, Commentary, NY Times: As the debate
over President Obama’s economic stimulus plan gets under way, one thing is
certain: many of the plan’s opponents aren’t arguing in good faith.
Conservatives really, really don’t want to see a second New Deal, and they
certainly don’t want to see government activism vindicated. So they are
reaching for any stick they can find with which to beat proposals for
increased government spending.

Some of these arguments are obvious cheap shots. John Boehner ... has
already made headlines with one such shot:... he derided a minor provision
that would expand Medicaid family-planning services — and called it a plan to
“spend hundreds of millions of dollars on contraceptives.”

But the obvious cheap shots don’t pose as much danger to the Obama
administration’s efforts to get a plan through as arguments and assertions
that are equally fraudulent but can seem superficially plausible... So as a
public service, let me try to debunk some of the major antistimulus
arguments... Any time you hear someone reciting one of these arguments, write
him or her off as a dishonest flack.

First, there’s the bogus talking point that the Obama plan will cost
$275,000 per job created. Why is it bogus? Because it involves taking the cost
of a plan that will extend over several years... and dividing it by the jobs
created in just one of those years. ... The true cost per job of the Obama
plan will probably be closer to ... $60,000...

Next, write off anyone who asserts that it’s always better to cut taxes
than to increase government spending because taxpayers, not bureaucrats, are
the best judges of how to spend their money.

Here’s how to think about this argument: it implies that we should shut
down the air traffic control system. After all,... surely it would be better
to let the flying public keep its money rather than hand it over to government
bureaucrats. If that would mean lots of midair collisions, hey, stuff happens.

The point is that nobody really believes that a dollar of tax cuts is
always better than a dollar of public spending. Meanwhile, it’s clear that ...
public spending provides much more bang for the buck than tax cuts — and
therefore costs less per job created (see the previous fraudulent argument) —
because a large fraction of any tax cut will simply be saved.

This suggests that public spending rather than tax cuts should be the core
of any stimulus plan. But rather than accept that implication, conservatives
take refuge in a nonsensical argument against public spending in general.

Finally, ignore anyone who tries to make something of the fact that the new
administration’s chief economic adviser has in the past favored monetary
policy over fiscal policy as a response to recessions.

It’s true that the normal response to recessions is interest-rate cuts from
the Fed, not government spending. ... But ... we’re in a situation not seen
since the 1930s: the interest rates the Fed controls are already effectively
at zero.

That’s why we’re talking about large-scale fiscal stimulus: it’s what’s
left in the policy arsenal now that the Fed has shot its bolt. ...

These are only some of the fundamentally fraudulent antistimulus arguments
out there. Basically, conservatives are throwing any objection they can think
of against the Obama plan, hoping that something will stick.

But here’s the thing: Most Americans aren’t listening. The most encouraging
thing I’ve heard lately is Mr. Obama’s reported response to Republican
objections to a spending-oriented economic plan: “I won.” Indeed he did — and
he should disregard the huffing and puffing of those who lost.

At the center of this virtuous circle were unions. In 1955, more than a third
of working Americans belonged to one. ... So many Americans were unionized that
wage agreements spilled over to nonunionized workplaces as well. ...

Fast forward to a new century. Now, fewer than 8% of private-sector workers
are unionized. Corporate opponents argue that Americans no longer want unions.
But public opinion surveys ... suggest that a majority of workers would like to
have a union to bargain for better wages, benefits and working conditions. ...

One point is clear: ... As our economy grew between 2001 and the start of
2007, most Americans didn't share in the prosperity. ... Home-equity loans and
refinancing made up for declining paychecks. But that's over. ...

The way to get the economy back on track is to boost the purchasing power of
the middle class. One major way to do this is to expand the percentage of
working Americans in unions. ... According to the Department of Labor, workers
in unions earn 30% higher wages ... and are 59% more likely to have
employer-provided health insurance...

Although America and its economy need unions, it's become nearly impossible
for employees to form one. ... The reason? Most of the time, employees who want
to form a union are threatened and intimidated by their employers. And all too
often, if they don't heed the warnings, they're fired, even though that's
illegal. I saw this when I was secretary of Labor... We tried to penalize
employers..., but the fines are minuscule. Too many employers consider them a
cost of doing business.

This isn't right. The most important feature of the Employee Free Choice Act,
which will be considered by ... Congress, toughens penalties against companies
that violate their workers' rights. The sooner it's enacted, the better...

The American middle class isn't looking for a bailout or a handout. Most
people just want a chance to share in the success of the companies they help to
prosper. ...

EPI tracked the initiative’s effectiveness through a website,
www.jobwatch.org, and found that it fell
far short of its goals. Not only did the promised 1.4 million additional jobs
not appear, but the 4.1 million jobs expected with no action also failed to
materialize. In all, only 2.4 million jobs were created—1.7 million short of the
administration’s projection without their new policy. Thus, by the Bush
administration’s own metrics the tax cut program fell short by a total of 3.1
million jobs (149,000 pr month). For an analysis of how the Bush 2003 tax plan
(The “Jobs and Growth" plan) fell short of its job claims see [here]...

On what basis can the conservatives who embraced those failed initiatives now
claim that tax cuts are the best policy?

It seems Republicans have but one answer to every problem, get government out of the way through tax cuts and deregulation. When they are asked what caused it, whatever it might be, there is one answer, government. When asked how to fix it, whatever it might be, there is but one answer, reduce government
through tax cuts and deregulation. For many, especially the politicians, it doesn't matter whether tax cuts will actually fix the economy, the goal is to reduce the size of government by any means, and they see this as an opportunity to do just that. If government is always the problem, then getting government out of the way is always the solution.

For many of the tax cut advocates on the right, this isn't really about job creation. Though job creation will get plenty of lip service, the right doesn't generally believe government intervention in any form, tax cuts or spending, is helpful as far as stabilizing the economy. They believe that cutting taxes can increase economic activity, reducing taxes gets the government out of the way and that will increase growth and jobs, but that is about the long-run and economic growth, it's not about stabilizing the economy in the short-run or about creating jobs to end a recession.

So the tax cut policy isn't really about stabilization policy. There could be jobs that are created from tax cuts, even in the short-run, but in its heart of hearts the tax cut policy is about cutting revenues at every opportunity in an attempt to reduce the size of government. If you doubt this, ask yourself what the right will argue when the economy starts to improve. Suppose we say at some point in the future, ok, now that things are better, it's time to increase taxes back where they were. What will we hear? What we'll hear is how raising taxes will kill the recovery, kill growth, cost us jobs, etc. According to this line of thinking, recessions are good times to cut taxes, but recoveries are horrible times to raise them (note, however, that this is wrong from a stabilization perspective - you should run a surplus in good times to cover deficits incurred in bad times). So once taxes ratchet down, it will be a fight to return them back where they started. That's because the real goal is not stabilization, with stabilization policy taxes would move freely in both directions, it's to reduce the size of government. And since the real goal is something besides stabilization, there's no reason to expect, and good reason not to expect, that the policy this group puts forth will be optimal (or even good) at providing short-run relief.

They already screwed this up once, the initial tax cut stimulus package put into place last spring was too small and poorly targeted, it had all sorts of problems all in the name of appeasing this same group - and here they are trying to muck up the process once again, to hold jobs hostage while they try to get tax cuts in place, even though something like 40% of the package is already devoted to tax cuts. Camel, tent, nose. I think it's time to stand up and say no, sorry, you lost the election, and not by just a little bit. You had your chance and look where we ended up - with a terrible economy, huge holes in the budget making it much harder to respond to the downturn, a financial sector wrecked by your anti-government, self-regulation philosophy, what is it about the past several years that would lead us to have any confidence at all you have the slightest clue how to manage a well-running economy instead of driving it into a ditch, let alone heal one that is broken?

Saturday, January 24, 2009

America's Fear of Competition, by Eliot Spitzer, Commentary, Slate: Although
everybody claims to love the market, nobody really likes the
rough-and-tumble of competition that produces the essential "creative
destruction" of capitalism. At bottom, this abhorrence of competition and change
are the common theme that binds together the near death of the American car
industry, the collapse of the credit market, the implosion of the housing
market, the SEC's disastrous negligence, the Madoff Ponzi scheme, and the other
economic catastrophes of recent months.

Consider the examples of the SEC and GM, which would appear to have nothing
to do with each other. The traditional critiques of the SEC have been that it
was underfunded and didn't have up-to-date laws needed to regulate sophisticated
financial transactions in evolving markets. That's not accurate. The SEC is a
gargantuan bureaucracy of 3,500 employees and a budget of $900 million... And
the ... powers of the SEC are so broad that it needs no additional statutory
power to delve into virtually any market activity that it suspects is improper,
fraudulent, or deceptive. ... The SEC has all the money and people and laws it
needs. For ideological reasons, it just didn't want to do its job, and on the
rare occasions when it did, it didn't know how.

GM's excuses—that its UAW contract and health care costs make it too top
heavy to compete—are partially true but ignore a simple reality: These are the
self-inflicted wounds of a company that chose a path of least resistance rather
than confront the need for dynamism and innovation. ... The auto industry
preferred protection to competition. And when it had to compete, it wasn't up to
the task.

Both the SEC and GM refused to adapt from the world of the last century to
the more dynamic new millennium. Each reacted the same way to competition:
Instead of improving its product, it played defense. ... No one at the SEC
seemed to ask the most important question: Given how the market is changing,
what should we change to insure the integrity of the capital markets?

Instead, the SEC spent its energy preventing others from doing the work it
should have done. Using the rather arcane doctrine of pre-emption, the SEC
fought in the courts and on Capitol Hill to keep other enforcers at bay:
Apparently, worse than having fraud in the marketplace was the possibility that
an entity other than the SEC would appear to be more effective than the SEC at
finding it.

For both the SEC and the auto industry, Congress was a place to find
protection from meaningful competition. Each used its bureaucratic clout to
insulate itself from the pressures of capitalism. ...

The result has been unfortunate: Over and over, we supplied the protection
from needed change that these entities desired. Then, when the going got tough,
neither the SEC nor GM was up to the task. By preventing the stern taskmaster of
competition from forcing adaptation, we became complicit in their becoming
dinosaurs. ... Both GM and the SEC need to see a change in market conditions as
an opportunity—not a challenge to market share.

We must rebuild these two institutions. If we don't infuse them with a
culture of change and love of competition, they will fail once again. ... This
is a unique opportunity for President Obama and the Congress to take two
seemingly different entities and force them to play by the real rules of
capitalism...

Congress and the executive branch have, to a considerable extent, been
devoted to business interests in recent years. In essence the argument is that
what's good for business is good not just for America, but for the whole world. The ideological basis for this approach is that the interests of business
and of greater society always coincide so that maximizing business interests maximizes social benefits at the same time, and that a hands off approach from government is the best
way to allow those coincident interests to express themselves.

Unfortunately, however, this ideological foundation incorporated a flawed understanding of the interaction between market structure and social benefits, particularly the ability of markets to self-correct when the market structures deviate from the socially optimal structure. The result of this, particularly as it came to be applied in the political arena, contributed to the existence of cronyism, rent-seeking, institutions that became too big, interconnected, and too powerful to fail, and other problems. Political power combined with
rigid ideology built upon a false premise - the doctrine of immediate self-correction by markets - gave us a result that was far from the competitive ideal presented in
textbooks, a world that was far from the ideal competitive model that produces such large benefits for society.

I think there is some understanding that the approach of the past did not
work, with the current state of the economy it's hard to argue that it did, and that we need to go in a new direction. And I'm sure we will try. But I
wonder, when all is said and done, will anything really change?

Behavior of Libor in the Current Financial Crisis, by Simon Kwan, Economic Letter, FRBSF: One of the key features of the financial turmoil of the
past year has been the credit crunch. For borrowing of many kinds, terms are
tougher and interest rates are higher, reflecting skyrocketing risk premiums. Of
particular importance are the elevated risk premiums on interbank loans—loans
that banks make to each other. The higher rates at which banks fund themselves
can raise the interest rates borne not just by bank borrowers, but also by
nonbank borrowers whose loan rates are tied to some of these interbank funding
costs. One consequence of these higher rates is that they partially offset the
effects of the monetary easing that the Federal Reserve has implemented since
the fall of 2007.

The London interbank offered rate, or Libor, is such a
rate, and it is widely used. Estimates are that, worldwide, a total of around
$150 trillion of financial products—in both the business and consumer
sectors—are indexed to the Libor. In addition, derivatives based on the Libor
are traded on futures exchanges.

Tyler Cowen
says he wants to see evidence about the effectiveness of fiscal policy. This is from Michael
Murray's econometrics text (which comes at the subject from an interesting
perspective), and it is one of his "Regression's Greatest Hits." It speaks to dynamic government spending multipliers, and the effect of government spending on economic growth:

Is Public Expenditure Productive?: From the 1930s to the late 1980s,
macroeconomists viewed government spending as rather homogeneous. They asked
whether government spending crowded out private investment, drove up interest
rates, or spurred consumer spending. They argued whether funding government
expenditures by taxation had different effects than funding by issuing new
government debt. They gave relatively little attention, however, to the
different ways the government spends its money-on defense, on roads, on food
stamps, and so on. Economist David Aschauer of Bates College dramatically
altered macroeconomists' view of government spending with a paper he wrote in
1989, however. Aschauer's analysis places a particular kind of government
spending - nonmilitary public investments, such as roads - at center stage. Aschauer
finds government investment is so important for private sector productivity that
a decline in public sector investment might account for much of the productivity
slowdown observed in the 1970s and 1980s.

Aschauer asks whether private sector productivity is improved by public
sector investments, and whether public sector investments have a different
effect on private sector productivity than does other government spending. He
assumes a Cobb-Douglas style of production function and uses two dependent
variables - output and a measure of productivity called "total factor
productivity - to study the effects of government spending on productivity.
Aschauer assumes that both output and productivity depend on labor, the private
capital stock, the public nonmilitary capital stock (for example, roads), and,
perhaps, on other government spending. He also allows output to depend on the
intensity with which the capital stock is being used, as measured by the
capacity utilization rate of the private sector.

When Aschauer estimates an output equation that accounts for labor, capacity
utilization, and a time trend, his Durbin-Watson statistic is 0.63. Either there
is serial correlation in the model's underlying disturbances, or an important
variable has been omitted. When Aschauer adds the public stock of nonmilitary
capital to the output equation, the Durbin-Watson statistic no longer evidences
serial correlation, and public capital becomes statistically significant.
The public, nnonmilitary capital stock is also significant in Aschauer's
productivity equation. Public investment expenditures translate into higher
private sector productivity and higher private sector output.

Aschauer finds no evidence of public military capital raising output or
productivity, nor does he find the flow of spending on on capital goods to have
any effect on output or productivity. Public spending raises private sector
productivity to the extent that public sector spending is on nonmilitary capital
goods. How government spends its money matters! It is not government spending,
as such, that spurs private productivity, but rather specific government
investments in capital goods that makes the private sector more productive.

We could reasonably worry that that the direction of causation runs not from government spending to output, but the other way around, from output (which
translates into income) to government spending. But if this were the reason for
Aschauer's findings, we would expect both military and nonmilitary capital to
reflect such an effect of output on expenditure. The fact that only public-sector spending
on nonmilitary capital goods shows a link with output suggests that the effect
we see reflects a causal effect running from nonmilitary capital to output, and
not the other way around.

But it was not to be. ... Just to be clear, there wasn’t anything glaringly
wrong with the address... But my real problem with the speech, on matters
economic, was its conventionality. ...Mr. Obama did what people in Washington do
when they want to sound serious: he spoke, more or less in the abstract, of the
need to make hard choices and stand up to special interests.

That’s not enough. In fact, it’s not even right.

Thus, in his speech Mr. Obama attributed the economic crisis in part to “our
collective failure to make hard choices and prepare the nation for a new age” —
but I have no idea what he meant. This is, first and foremost, a crisis brought
on by a runaway financial industry. And if we failed to rein in that industry,
it wasn’t because Americans “collectively” refused to make hard choices; the
American public had no idea what was going on, and the people who did know ...
mostly thought deregulation was a great idea.

Or consider this statement...: “Our workers are no less productive than when
this crisis began. Our minds are no less inventive, our goods and services no
less needed than they were last week or last month or last year. Our capacity
remains undiminished. But our time of standing pat, of protecting narrow
interests and putting off unpleasant decisions — that time has surely passed.”

This ... was almost surely ... a paraphrase of words ... Keynes wrote as the
world was plunging into the Great Depression... “The resources of nature and
men’s devices,” Keynes wrote, “are just as fertile and productive as they were.
The rate of our progress towards solving the material problems of life is not
less rapid. We are as capable as before of affording for everyone a high
standard of life. ... But today we have involved ourselves in a colossal muddle,
having blundered in the control of a delicate machine, the working of which we
do not understand.”

But something was lost in translation. Mr. Obama and Keynes both assert that
we’re failing to make use of our economic capacity. But Keynes’s insight — that
we’re in a “muddle” that needs to be fixed — somehow was replaced with standard
we’re-all-at-fault, let’s-get-tough-on-ourselves boilerplate. ...

Remember, Herbert Hoover didn’t have a problem making unpleasant decisions:
he had the courage and toughness to slash spending and raise taxes in the face
of the Great Depression. Unfortunately, that just made things worse.

Mr. Obama is ... going to have to make some big decisions very soon. In
particular, he’s going to have to decide how bold to be in his moves to sustain
the financial system, where the outlook has deteriorated so drastically that a
surprising number of economists, not all of them especially liberal,... argue
that resolving the crisis will require the temporary nationalization of some
major banks.

So is Mr. Obama ready for that? Or were the platitudes in his Inaugural
Address a sign that he’ll wait for the conventional wisdom to catch up with
events? If so, his administration will find itself dangerously behind the curve.

And that’s not a place that we want the new team to be. The economic crisis
grows worse, and harder to resolve, with each passing week. If we don’t get
drastic action soon, we may find ourselves stuck in the muddle for a very long
time.

Does Stimulus Stimulate?, by Bruce Bartlett, Forbes.com: ...The [Great
Depression] didn't really end
until both monetary and fiscal policy became expansive with the onset of World
War II. At that point, no one worried any more about budget deficits, and the
Fed pegged interest rates to ensure that they stayed low, increasing the money
supply as necessary to achieve this goal.

It was then and only then that the Great Depression truly
ended. As a consequence, economists concluded that an expansive monetary and
fiscal policy, which had been advocated by economist John Maynard Keynes
throughout the 1930s, was the key to getting out of a depression.

Keynes was right, but many of his followers weren't. They
thought that budget deficits would stimulate growth under all
circumstances, not just those of a deflationary depression. When this medicine
was applied inappropriately, as it was in the 1960s and 1970s, the result was
inflation.

Economists then concluded that it was a mistake to pursue countercyclical
fiscal policy, and the idea of "fine-tuning" became a derogatory term. ...

In the 1980s and 1990s, economists came around to the view that only monetary
policy could act quickly enough to reverse or moderate a recession. ... [But...] As we have seen, the Fed could not prevent the greatest
financial downturn the world has seen since 1929. This has revived the idea that
fiscal policy must be the engine that pulls us out.

Somewhat surprisingly, there has been rather heated
opposition to the very principle of fiscal stimulus... We have now had several tests of the Keynesian idea--most
recently with last year's $300 tax rebate... According to a
new paper by University of Michigan economists Matthew Shapiro and Joel
Slemrod, only a third of the money was spent, thus providing very little "bang
for the buck."

The failure of rebates has shifted the focus to public
works and other direct spending measures as a means of stimulating aggregate
spending. A
study by Obama administration economists Christina Romer and Jared Bernstein
predicts that the stimulus plan being debated in Congress will raise the gross
domestic product by $1.57 for every $1 spent.

Such a multiplier effect has been heavily criticized by a
number of top economists, including
John Taylor of Stanford,
Gary Becker and
Eugene Fama of the University of Chicago and
Greg Mankiw and
Robert Barro of Harvard. The gist of their argument is that the government
cannot expand the economy through deficit spending because it has to borrow the
funds in the first place, thus displacing other economic activities. In the end,
the government has simply moved around economic activity without increasing it
in the aggregate.

Other reputable economists have criticized this position as
being no different from the pre-Keynesian view that helped make the Great
Depression so long and deep.
Paul Krugman of Princeton,
Brad DeLong of the University of California at Berkeley and
Mark Thoma of the University of Oregon have been outspoken in their belief
that theory and experience show that government spending can expand the economy
under conditions such as we are experiencing today.

I think the critics of an activist fiscal policy are
forgetting the essential role of monetary policy as it relates to fiscal policy.
As Keynes was very clear about, the whole point of fiscal stimulus is to
mobilize monetary policy and inject liquidity into the economy. This is
necessary when nominal interest rates get very low, as they are now, because Fed
policy becomes impotent. Keynes called this a liquidity trap, and I think there
is strong evidence that we are in one right now.

The problem is that fiscal stimulus needs to be injected right now to counter
the liquidity trap. If that were the case, I think we might well get a very high
multiplier effect this year. But if much of the stimulus doesn't come online
until next year, when we are likely to be past the worst of the slowdown, then
crowding out will greatly diminish the effectiveness of the stimulus, just as
the critics argue. ... Thus the argument really boils down to a question of
timing. ...

For this reason, I think there is a better case for
stimulating the economy through tax policy than has been made. Congress can
change incentives instantly by, for example, saying that new investments in
machinery and equipment made after today would qualify for a 10% Investment Tax
Credit...

Stimulus based on private investment also has the added
virtue of establishing a foundation for future growth, whereas consumption
spending does not. As economist
Hal Varian of the University of California at Berkeley recently put it,
"Private investment is what makes possible future increases in production and
consumption. Investment tax credits or other subsidies for private sector
investment are not as politically appealing as tax cuts for consumers or
increases in government expenditure. But if private investment doesn't increase,
where will the extra consumption come from in the future?"

I don't agree with all of this, e.g. the "government is always the
problem" emphasis in the analysis, and casting the debate as a tradeoff between
private investment and private consumption rather than between private sector
activity (consumption or investment) and public investment overstates the case
for private sector solutions. [These arguments from yesterday apply as well.]

I've never objected to tax cuts being part of the package -- I have also
argued that the desire for an immediate impact may necessitate some tax cut
components in order to maximize the prospects for a faster recovery. And as tax
cuts go, there are far worse choices than an investment tax credit. But just as
there's a limit to the number of public sector projects that are shovel ready,
there's also a limit to the number of private sector projects that are ready to
go (though the planning stage does involve some spending, just not as much as
when the public or private sector investment projects are going full throttle).
There's also a question about how strong the reaction will be to a tax credit
when the economic outlook is so gloomy, a question that doesn't arise when
government is making the investments. So, sure, let's get as much out of the
private sector as we can, but we shouldn't rely solely upon the private sector
response to a tax credit to turn things around. It's very unlikely to be enough
on its own, and it may not provide much help at all, Thus, even with tax
credits, the public sector response - government spending in particular - still
needs to be aggressive.

Threading a Needle, by Tim Duy: I have been on the road or swamped for
much of this week, and saw this in the
Wall Street
Journal when I finally got time to sit down with my computer:

President Barack Obama's nominee for Treasury secretary accused China on
Thursday of "manipulating" its currency, a sharp rhetorical break from the Bush
administration's approach to Beijing's controversial exchange-rate policy.

Bloomberg, however, had a more nuanced take on the news:

Timothy Geithner’s warning that President
Barack Obama believes China is “manipulating” its currency may trigger
renewed tensions between two of the world’s three biggest economies.

Who believes China is a manipulator? Secretary Geithner or President Obama?
One of the relevant sections of Geithner’s
written responses suggests the latter:

President Obama - backed by the conclusions of a broad range of economists –
believes that China is manipulating its currency. President Obama has pledged as
President to use aggressively all the diplomatic avenues open to him to seek
change in China's currency practices.

More broadly, we look forward to a productive economic dialogue with the
Chinese government on a number of short- and long-tem issues. The Yuan is
certainly an important piece of that discussion, but given the crisis the
immediate focus needs to be on the broader issue of stabilizing domestic demand
in China and the US. The latest figures show that China’s growth in 2008 was 9%,
a full 4 percentage points lower than in the previous year. Because China
accounts for such a large fraction of the world economy, a further slowdown in
China would lead to a substantial fall in world growth (and demand for US
exports) and delay recovery from the crisis. Therefore, the immediate goal
should be for us to convince China to adopt a more aggressive stimulus package
as we do our part to try to pass a stimulus package here at home.

Geithner sounds like he is either heeding to direction of the President or
wants to absolve himself of responsibility should the “discussion” with China
goes awry (Felix
Salmon suggests that Geithner is getting very good at absolving himself from
responsibility for things gone wrong).

The drop in Treasuries sent yields on benchmark 10-year notes to as high as
2.63 percent, the highest level in almost six weeks. China held about $682
billion of Treasuries as of November, and overtook Japan as the biggest overseas
owner of the debt last year.

Certainly, Geithner’s comment may have just been an excuse for traders to do
what they wanted to do anyway, sell Treasuries. That seems to
be something of a trend of late:

Treasury benchmark notes headed for their fourth weekly loss in five as
President
Barack Obama’s spending plans led traders to add to bets on faster
inflation.

The
difference between rates on 10-year notes and Treasury Inflation Protected
Securities, which reflects the outlook among traders for consumer prices,
widened to a nine-week high of 67 basis points.

“People are demanding a larger premium to hold U.S. bonds,” said
Satoshi Okumoto, general manager in Tokyo at Fukoku Mutual Life Insurance
Co., which has $61.4 billion in assets. The insurer trimmed its holdings in
December, he said.

Bonds declines have tended to be shorted lived in recent months, but may also
corresponded to a renewed, albeit fragile appetite for risk. As CR points out,
some bond spreads
are narrowing. A greater appetite for risk should push investors out of
low-yielding Treasuries into higher yielding assets. And if these trends were to
continue – A BIG IF – financing the impending US deficit spending may not be as
cheap as currently believed. Add in two more pieces:

GEITHNER ON U.S. DEFICIT, ENTITLEMENT PROGRAMS: "It is absolutely critical
to the efforts to get the economy back on track that we give the American people
and investors around the world confidence that we're going to have the ability
and the will, working with the Congress, to get our fiscal position back down
over the next five years to a sustainable position, but also that we're willing
to start to take on and find a consensus on a bipartisan basis for putting
Social Security and Medicare on a more sustainable financial position longer
term.

Mr. Geithner said the tax incentives included in the stimulus package would
have a "substantial and quick-acting effect" and that the Obama administration
"tried to be careful [to] limit long tails."

Taken together, these bits and pieces imply the Obama Administration is
attempting to thread a very tight needle: Provide enough stimulus to keep
unemployment from soaring well into the double digits while taking long term
concerns about the national debt seriously. This would account for what many
believe to be a relatively tepid and insufficient stimulus package. Presumably,
they want to avoid “long tails” for policy that extends stimulus related deficit
spending into the time horizons when the US Treasury will be forced to float
publicly traded debt to fund entitlement obligations. Silly as it may seem given
the recent runaway demand for Treasuries, the incoming officials may be greatly
concerned about the sustainability of that trend.

At the same time, they want to lessen dependence on China, which requires
that Chinese policymakers stimulate domestic demand to a sufficient extent to
allow for China to ease purchases of Treasuries and allow the Yuan to appreciate
in a nondisruptive fashion. Seems like a steep expectation for the
export-dependent Chinese, you are now faced with
faltering growth rates. If the Chinese don’t cooperate, a portion of any US
stimulus is lost to higher imports – always remember that the US doesn’t have
much excess productive capacity in tradable goods. The excess capacity exists in
China. And Congress would be less than happy to see US tax dollars supporting
Chinese jobs.

And, as if that wasn’t enough, the Fed would have to cooperate, and allow US
rates to rise to encourage private investors to purchase debt as Chinese
purchases ease. That, however, would raise borrowing costs to consumers (who are
not in a position to acquire more debt anyway) as well as mortgage rates (which
are bouncing upwards). Would Bernanke & Co. be willing to allow rates to rise,
even on the long end, given recent avowals to support consumer spending and
housing markets at virtually any cost? Tough to see...especially if unemployment
is well into the upper single digits, and given concerns about withdrawing
stimulus too early. As it is, I imagine the Fed is already getting nervous that
efforts to contain mortgage rates have been less than effective.

Moreover, China is only one player. Geithner & Co. would have to convince
European policymakers that it was no in their best interest to take advantage of
US and Chinese stimulus to depreciate the Euro. In other words, we need to all
rise together or all sink together.

All in all, a remarkably tricky policy maze to navigate…and I find myself
with more questions than answers…even before considering the additional
complications of a fresh rescue attempt for the financial system.

Thursday, January 22, 2009

The right and wrong way to bail out the banks, by George Soros, Commentary,
Financial Times: According to reports..., the Obama
administration may be close to devoting as much as $100bn of the second tranche
of the troubled asset relief programme funds to creating an “aggregator bank”
that would remove toxic securities from the balance sheets of banks. The plan
would be to leverage this amount up 10-fold, using the Federal Reserve’s balance
sheet, so that the banking system could be relieved of up to $1,000bn worth of
bad assets. ...

[T]his approach harks back to
the approach originally taken – but eventually abandoned – by Hank Paulson...
The proposal suffers from the same shortcomings... These measures ... would ... support ... banks at considerable expense to the
taxpayer, but would not put the banks in a position to resume lending at
competitive rates. ...

And right now, with so much of our infrastructure in need of attention, we need public goods.

We tried the tax cut approach to stimulating the economy once, we had no choice since Bush and the Republicans would not have passed any other type of stimulus package.

Guess what? It didn't work very well, and we have little to show for it. Had we, say, rebuilt water systems instead, at the very worst we'd have better water. That's not so bad in any case.

And it's been interesting, if that's the right word, to watch the same people who delayed fiscal policy for months and months and months as they insisted that we try tax cuts first now tell us that it will take too long to put the spending in place. They don't seem to realized that's because of their insistence on the use of tax cuts rather than spending. If we had started on these projects a year ago instead of enacting the tax cut package to appease the right, timeliness would not be such an issue - we might already be repairing sewage systems, rebuilding roads, and so on. I've even heard some who ought to know better argue that because forecasts say the recession will end soon, we can't possibly get the spending in place soon enough. That is, they argue that by the time the spending hits the economy, the economy will have already recovered (these are often the same people who reassured us that there was no housing bubble, and there was not worry anyway because the recession, if it hit at all, would be very mild and easily absorbed by our dynamic, flexible economy). Never mind that forecasts beyond around six months ahead are not much better than a coin flip, and they know it, some forecast somewhere says that the recession will end before spending is in place, and that's enough for them to take the argument public. What if the forecast is wrong?

It's not completely clear to me that the fact that the recession might end soon undercuts the case for government spending anyway. If the money is spent on large, socially beneficial projects - and lots of infrastructure comes under this heading - then so what if the economy recovers? These are things we very much need, and that won't change just because the economy is doing better. There will be net benefits no matter the state of the economy, but the net benefits will be higher if we pursue these projects when the costs are low. If we are lucky, and the economy recovers very fast, much faster than expected, then there will still be benefits, they just won't be as large.

We need to do these things, and right now, with so many idle resources in the economy, the opportunity cost of employing resources is low. For this reason, this is an opportune time to meet the challenges that we face in repairing the infrastructure and in meeting other needs that are critical to maintaining robust economic growth, and in maintaining our health and welfare.

The tax cuts are better than spending proponents generally ignore public goods when they argue that the private sector is always better at spending money, but it seems to me that leaves out an important part of the argument.

If the argument that the private sector is more efficient than government always prevailed, we wouldn't have any public goods at all, and that's not an economy I'd want to live in. Obviously, there are times when spending on public goods is justified economically, and I'd argue strongly that this is one of those times, i.e. that there are lots of places the government can spend money that have large social returns. Why would we want to wait until the opportunity cost is very high to reap these returns instead of pursuing these projects now when the cost is lower? If we are going to have to make these expenditures anyway, it doesn't make any sense to wait.

And one last question. The tax cuts are best crowd argues that government makes poor spending decisions, and this is one of their key objections to spending measures. But doesn't government make bad tax decisions too? The tax cut advocates like to promote some tax they've designed that has wonderful properties on paper, and sounds great on the editorial page, but it's just as easy to do that with fiscal policy. If you don't have to confront the reality of the legislative process, and you are free to argue from a theoretical perspective instead, not a dollar will get wasted. But as we saw during the first fiscal stimulus attempt, the one where the "it has to be tax cuts or nothing" types prevailed, the tax cuts that were actually enacted were far from optimal, and there was quite a bit of disappointment in the actual tax cut package that was put into place. And perhaps because of that, the tax cuts had less effect than hoped. I know that the tax cut advocates say that this time government needs to do it right, and they have lots of advice about what "right" is, but, really, given the realities in congress, what makes them think this time will be any different?

The latest entry:
Robert Barro
argues that the multiplier on government spending is low because real GDP during
World War II rose by less than military spending.

Actually, I’ve already
taken that one on. But just to say it again: there was a war on.
Consumer goods were rationed; people were urged to restrain their spending to
make resources available for the war effort.

Oh, and the economy was at full employment — and then some. Rosie the
Riveter, anyone?

I can’t quite imagine the mindset that leads someone to forget all this, and
think that you can use World War II to estimate the multiplier that might
prevail in an underemployed, rationing-free economy.

I'm still puzzled as to where Smith draws the line with regard to government
intervention. In Book V, Chapter I, he talks about justice, defence and public
works but it seems that he has a wider application for the state in market
matters. I'd be very interested to hear your viewpoint on this.

To which I replied:

Yes, it is widely believed, even by some top academic economists, especially
on Blogland, that Adam Smith favoured small government, often represented by the
phrase, the 'night watchman state', which in fact was coined in the late 19th
century by a firebrand socialist.

I have posted this list from my book, Adam Smith: a moral philosopher and
his political economy' (2008, pp 247-48, Palgrave Macmillan):

"The Navigation Acts, blessed by Smith under the assertion that ‘defence,
however, is of much more importance than opulence’; (WN464)

Sterling marks on plate and stamps upon linen and woollen cloth (WN138-9)

Enforcement of contracts by a system of justice; (WN720)

Wages to be paid in money, not goods;

Regulations of paper money in banking; (WN437)

Obligations to build party wars to prevent the spread of fire; (WN324)

Rights of farmers to send farm produce to the best market (except ‘only in
the most urgent necessity’);(WN 539)

Premiums and other encouragements to advance the linen and woollen
industries’; (TMS185)

‘Police’, or preservation of the ‘cleanliness of roads, streets, and to
prevent the bad effects of corruption and putrifying substances’;

ensuring the ‘cheapness or plenty [of provisions]’; (LJ6; 331)

patrols by town guards, fire fighters and of other hazardous accidents;
(LJ331-2)

Erecting and maintaining certain public works and public institutions
intended to facilitate commerce (roads, bridges, canals and harbours); (WN723)

Jacob Viner concluded, unsurprisingly, that Adam Smith was not a doctrinaire
laissez-faire advocate.

[From Viner, J. 1928. ‘Adam Smith and Laissez-faire’, In ‘Adam Smith,
1776-1928: Lectures to Commemorate the Sesquicentennial of the Publication of
Wealth Of Nations, p 53, August M. Kelly, Fairfield, NJ; I provided the
references to Wealth Of Nations.]

...The pure theory of markets, such as neoclassical economics and general
equilibrium as much that it is meritorious, but it is a theory not a description
of how markets actually work.

The players in markets are real human beings, not variables that operate
within narrow confines of deterministic mathematics. ...
The message is clear: start with the history, how things arrived at their
present day circumstances and arrangements, and observe how they operate,
drawing on lessons of how they worked, more or less, well in the past and what
that teaches us selectively about what works and what doesn’t, assemble general
principles that seem to be of practical benefit to assumed goals, and apply them
to current events and trends.

Of course, everything depends on the selection and the objectives. ...Smith’s objective function was how an economy, the State, and the people,
could spread opulence from commerce to the nation, especially the poor majority,
drawing on how nations remained stable (justice and the distinction of ranks),
became prosperous (the desire of people to ‘better themselves’) given as much
freedom to do so (Liberty) without it degenerating into monopoly, restrictive
protectionism, and opulence for a minority using their political influence over
the State, while leaving the poor as they had been left throughout all history
as serfs, slaves, and penurious labourers.

Smith believed that a commercial society was the best opportunity for
continual growth and the spread of opulence, and showed in his critique of
mercantile political economy, as it had operated since the 15th century and was
operating up to the Fall of Rome in the 5th century, what changes might be made
by the legislature to let commerce do its work as speedily as was practicable in
the real world and not in some kind of impossible utopia.

He was not an ideologue. His understanding of history demonstrated what was
possible among real men as they were, not ideal ‘guardians’ of public interest
who usually made everything worse than it need be.

Hence, his proposals for ‘public works and public institutions’, which were
written in is inimitable style, were apparently quite modest (the incorrect
‘take’ on them by laissez-faire ideologues), though they added to a level of
state expenditure that was actually quiet ambitious, with separately argued
cases for the items listed by Jacob Viner in 1928 above, which together extended
the agenda of appropriate expenditure by a classical liberal state (and even one
ran by quite illiberal personnel).

It is impossible to imagine a continuous gale of creative destruction taking
place except in a context of boom and bust. Indeed, early theorists of business
cycles understood this. ...

In classic business-cycle theory, a boom is initiated by a clutch of
inventions – power looms and spinning jennies in the 18th century, railways in
the 19th century, automobiles in the 20th century. But competitive pressures and
the long gestation period of fixed-capital outlays multiply optimism, leading to
more investment being undertaken than is actually profitable. Such
over-investment produces an inevitable collapse. Banks magnify the boom by
making credit too easily available, and they exacerbate the bust by withdrawing
it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist,
wrote: "I do not feel confident that a policy which, in the pursuit of stability
of prices, output, and employment, had nipped in the bud the English railway
boom of the forties, or the American railway boom of 1869-71, or the German
electrical boom of the nineties, would have been on balance beneficial to the
populations concerned." Like his contemporary, Schumpeter, Robertson regarded
these boom-bust cycles, which involved both the creation of new capital and the
destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on
top of these early models... It manages to combine technology-driven cycles of
booms and recessions with markets that always clear (i.e. there is no
unemployment).

How is this trick accomplished? When a positive technological "shock" raises
real wages, people will work more, causing output to surge. In the face of a
negative "shock", workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by
government is needed. Bailing out inefficient automobile companies such as
General Motors only slows down the rate of progress. In fact, whereas most
schools of economic thought maintain that one of government's key
responsibilities is to smooth the cycle, "real" business-cycle theory argues
that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today's economic
turbulence, or offers sound instruction about how to deal with it. First, in
contrast to the dot-com boom, it is difficult to identify the technological
"shock" that set off the boom. Of course, the upswing was marked by
super-abundant credit. But this was not used to finance new inventions: it was
the invention. It was called securitised mortgages. It left no monuments to
human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do
nothing in the face of such "shocks". Indeed, "real" business-cycle economists
typically argue that, but for Roosevelt's misguided New Deal policies, recovery
from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing
all the wrong things in bailing out top-heavy banks, subsidising inefficient
businesses, and putting obstacles in the way of rational workers spending more
time with their families or taking lower-paid jobs. ...

Although Schumpeter brilliantly captured the inherent dynamism of
entrepreneur-led capitalism, his modern "real" successors smothered his insights
in their obsession with "equilibrium" and "instant adjustments". For Schumpeter,
there was something both noble and tragic about the spirit of capitalism. But
those sentiments are a world away from the pretty, polite techniques of his
mathematical progeny.

John Quiggin says the world financial system is in need of radical restructuring:

In which I disagree with Paul Krugman, by John Quiggin: As James Surowiecki
points out
here, my views on what’s entailed in bank nationalisation differ
significantly from those of
Paul Krugman.[1] Krugman, like quite a few other advocates of
nationalisation, has in mind models like the Resolution Trust Corporation and
the Swedish nationalizations of the 1990s, where the government took insolvent
institutions into temporary public ownership, liquidated the bad assets and
returned them to the private sector. These solutions worked well because the
global financial system as a whole was solvent and liquid, even though some
sectors (US S&Ls, Swedish banks) were not.

What’s needed in the present case is not only to fix the problems of
individual banks, problems on a much bigger scale than have been seen before...,
but to reconstruct a failed global financial system. ... The job is likely to be
much slower than the rescues mentioned above, and the institutions that emerge
from it will be very different from those that went in.

But, contra Surowiecki this time, this only strengthens the argument for
nationalisation. Financial restructuring is going to be a huge challenge,
involving both a radical redesign of national regulations and the construction
of an almost completely new global financial architecture. ...
___________________________
[1] Krugman is well-known for being right when lots of others have been wrong,
so take this into account in assessing the arguments.

The ability of countries to work cooperatively to reconstruct the financial
system will be a test case for our ability to work together to solve global
warming. If we cannot find a way to work together to fix the problems with the
global financial system even though there is such a clear need to do so, that will not be a
good sign. But perhaps this works the other way too. If we do somehow manage to work together and improve the financial architecture, that could help to set the stage for further cooperative efforts in the future.

A Breakthrough Against Hunger, by Jeffrey D. Sachs, Project Syndicate:
Today's world hunger crisis is unprecedentedly severe and requires urgent
measures. Nearly one billion people are trapped in chronic hunger - perhaps 100
million more than two years ago. Spain is taking global leadership in combating
hunger by inviting world leaders to Madrid in late January to move beyond words
to action. ...

The benefits of some donor help can be remarkable. Peasant farmers in Africa,
Haiti, and other impoverished regions currently plant their crops without the
benefit of high-yield seed varieties and fertilizers. The result is a grain
yield ... that is roughly one-third less than what could be achieved with better
farm inputs. African farmers produce roughly one ton of grain per hectare,
compared with more than four tons per hectare in China, where farmers use
fertilizers heavily.

African farmers know that they need fertilizer; they just can't afford it.
With donor help, they can. ... Dozens of low-income, food-deficit countries, perhaps as many as 40-50, have
elaborated urgent programs for increased food production by small farms, but are
currently held back by the lack of donor funding. ... Hundreds of millions of
people, in the meantime, remain trapped in hunger.

Many individual donor countries have declared that they are now prepared to
increase their financial support for smallholder agriculture, but are searching
for the appropriate mechanisms to do so. The current aid structures are
inadequate. The more than 20 bilateral and multilateral donor agencies for
agriculture are highly fragmented and of insufficient scale individually and
collectively. ...

My colleagues and I, serving on an advisory committee for the Spanish
initiative, have recommended that donors pool their funds into a single
international account, which we call the Financial Coordination Mechanism (FCM).
These pooled funds would enable farmers in poor countries to obtain the
fertilizer, improved seed varieties, and small-scale irrigation equipment that
they urgently need.

Poor countries would receive prompt and predictable financing for
agricultural inputs from a single account, rather than from dozens of distinct
and fragmented donors. By pooling financial resources into a single-donor FCM,
aid programs' administrative costs could be kept low, the availability of aid
flows could be assured, and poor countries would not have to negotiate 25 times
in order to receive help.

The time for business as usual is over. The donors promised to double aid to
Africa by 2010, but are still far off track. Indeed, during the past 20 years,
they actually cut aid for agriculture programs, and only now are reversing
course.

Meanwhile, a billion people go hungry each day. ... History can be made in
Madrid at the end of January... The lives of the billion poorest people depend
on it.

Perhaps, with a new administration, we'll see more emphasis and leadership on
these issues. That would be a welcome change.

Tuesday, January 20, 2009

When I talk about the need for government intervention in the marketplace,
the justification for the intervention usually relies upon the presence of substantial market failures
of one sort or another. However, as Robert Waldmann often
points out
in comments to those posts, government intervention can
be justified in other ways besides the traditional list of market failures, e.g. the presence of dynamically inconsistent
preferences can be used to justify forced saving for retirement. The discussion
below looks at how governments ought to respond to the current problems in the
economy if a key assumption of economic models, rationality, is dropped and replaced with an assumption that agents have bounded
rationality:

The “homo economicus” model of rational agents, acting to maximise utility in
the possession of all available information, is not realistic. It is hardly a
credible way to look at human beings – but we tolerate it because it is simple
enough to allow equilibrium analysis which often gives reasonable predictions.

However, these equilibrium models are not serving very well in today’s
situation. Standard monetary policy and (to a lesser extent) Keynesian theories
are based on rational-actor assumptions. They give broad recommendations about
monetary loosening and fiscal expansion – which central banks and governments
are rightly trying out. But growth is not resuming.

Bounded rationality is the broad term for behavioural models that do
not follow the rational-maximiser formula. There is not yet a generally accepted
alternative model. Lots of individual non-rational behaviours have been
discovered, but they are grafted onto a rather clunky ‘rational actor with bits’
instead of forming a coherent behavioural model.

However, the best place to test a new theory is often at the edges of the old
one, where the existing model breaks down. So the current troubles in the
financial and real economy may be a good opportunity to try out some alternative
models and see which give a reasonable description of what we see.

Models of bounded rationality

Different models of bounded rationality vary basic assumptions of the
rational agent model in different ways. Some of those assumptions are: